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Industry Spotlight > Broker Dealers

Time for Discipline

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After 30 years in the investment adviser and broker-dealer industry I have discovered a few truisms, which I felt needed to be shared in this sixth installment of an ongoing series: Almost everything cycles, and those this forget that end up in big trouble; the economy, interest rates, stock prices, commodity prices, real estate prices and the rest go up and down, whatever the long-term trend.

During every boom, there are be prognosticators that declare that there have been structural changes — and things can go up forever, as was recently the case with housing prices. The bust comes, and there’s not enough revenue to go around, so half the people leave the real-estate industry. When the next boom comes, it’ll start with revenues shared among many fewer real-estate brokers, the survivors.

And it is no different in the investment adviser and broker-dealer industry. These patterns repeat themselves over and over.

The major firms face high overhead spread among a falling revenue base. All the recruiting and retention deals that were modeled on assumptions of rising revenues become a great burden on financial performance. Lower producers are terminated; one firm just terminated every adviser doing less than $250,000 in annual revenues.

Payout is cut, but often mostly at the lower end putting pressure on lower producers. Staff and other support is cut and cut. There is less help and more burdens, and it is easier to have errors and mistakes as a result. Training programs for new advisers are cut or eliminated.

For lower level producers, the first issue to confront is whether this viciously cyclical industry is the place for them. If it is, the second issue is how to survive the cycle. You may have to look to smaller firms, boutiques, independent contractor firms, the large brokerage houses will not be the most hospitable employers.

People in the compliance side of the industry during a down cycle refer to the “ratchet effect.” Advisers who have not experienced the severe cycles in the industry, and, unfortunately, some who have, ratchet up their life styles during the good times to a level that can not be supported by the declining fees and commissions. This has many impacts. Some advisers suffer severe depression. We should all watch our colleagues and people who feel the need should seek help.

But the pressure leads some advisers to do bad, or foolish, or desperate things. If you want to be a survivor and prosper when the cycle turns, discipline is necessary.

Advisers with no bad intent can find themselves doing foolish things as the pressure mounts, trying to find the magic formula to generate revenues.

Most important, communicate with clients. It can become painful to keep picking up the phone while clients are losing money; they are angry, scared, frustrated, and you have no easy answers. Some advisers stop communicating. This leads to complaints and arbitrations, and no clients on the other side of the cycle. It may be hard to switch from marketing to comforting and reassuring clients in tough times, but you have to do it.

While there are no absolute truths, some temptations that lead advisers to disaster seem to repeat themselves over and over in tough times, and in good times also to some extent. Let’s review them:

1. If it is too good to be true it is probably not. A supposedly safe and secure debt instrument paying a huge commission and way over market returns is not likely possible unless the sponsor is a magician or a crook.

2. If you do not completely understand a product, do not sell it. Many of the arcane and indecipherable products designed by the rocket scientists at the major firms would have been avoided by this and the prior rule. And if you can, avoid the deals where the documents give the clients no rights, the sponsor the ability to take their money and suspend redemptions, and answer to no one. I have seen too many advisers stunned after the fact that they sold a product that said that; they never read the documents.

3. If you do not know that someone has completely vetted everyone and everything involved in a product, do not get involved. Many times I have seen people selling products for sponsors with criminal records that no one checked. If the due diligence department did not do background checks of all people involved and independently confirm all critical items, stay away.

4. Forgetting that cycles are inevitable can destroy your practice, and trying to time the peaks and valleys to the very top and bottom is also a formula for failure. Selling half, taking some portion off the table, will never be right in hindsight on the way up or the way down, but if you communicate well with your clients you may find this ‘wrong’ act is often the best approach.

5. If you have given warnings to a client, if a client insists on taking risk in excess of your advice, you need written proof. Often a case will come down to a client’s claim that something is not his or her signature; protect yourself by having proof.

6. You cannot let a client commit financial suicide no matter how intelligent they appear, fire them as a client first.

7. Illiquid products are for limited and careful use. This includes investments that can be illiquid under the governing documents.

8. Take on client carefully. Some people you know will be trouble the day you meet them, but in tough times you might be tempted to take a client you should not. Don’t do it.

9. Past performance does not guarantee future performance. I have seen too many advisers over the years who believe they have discovered the secret of successful money management and end up betting their whole practice on the formula they discovered.

They form a separate account adviser or a hedge fund or just put all their clients in accounts they manage with the same methodology. This is a classic failure to diversifying your business.

10. The same principal of diversification applies to falling on love with certain investments. If every client concentrated in gold, every client concentrated in commodities, every client in a particular private fund, this is a major risk to your practice.

11. If you would not put your mother’s money into an investment, do not put your client’s money into it.

Steve has represented hundreds of the top financial advisers in the United States in changing firms or setting up their own firms for decades. Questions can be sent to Steve at [email protected]